Legal Definitions - formula AB trust

A Formula AB Trust is a sophisticated estate planning tool used by married couples to minimize federal estate taxes and ensure their assets are distributed according to their wishes. It is a specific type of AB Trust where the division of assets into two separate trusts upon the death of the first spouse is determined by a precise formula, typically designed to utilize the maximum available federal estate tax exemption.

Here's how it generally works:

When the first spouse passes away, their assets are divided into two distinct trusts:

• Trust B (Bypass Trust or Credit Shelter Trust): This trust is funded with assets from the deceased spouse's estate, up to the current federal estate tax exclusion amount (the maximum value of assets an individual can pass on without incurring estate tax). The "formula" ensures this amount is precisely met. Trust B is irrevocable and is designed to "bypass" the surviving spouse's estate for estate tax purposes, meaning its value will not be included in the surviving spouse's taxable estate when they eventually pass away. While the surviving spouse may receive income from Trust B to support their lifestyle, they typically do not have full control over the principal, which is usually designated for other beneficiaries, such as children or grandchildren.
• Trust A (Marital Trust or Survivor's Trust): This trust holds the remaining assets from the deceased spouse's estate (if any exceed the exclusion amount) and all of the surviving spouse's separate assets. The surviving spouse typically has full control over Trust A, including the ability to use the principal and designate beneficiaries. Assets in Trust A are generally included in the surviving spouse's taxable estate upon their death.

The primary benefit of a Formula AB Trust is its ability to effectively use both spouses' individual estate tax exemptions, potentially allowing a married couple to pass on a significantly larger estate free of federal estate taxes to their ultimate beneficiaries.

Examples of a Formula AB Trust in action:

• Protecting a Large Estate for Future Generations:

  Imagine John and Mary, a married couple with a combined estate valued at $25 million. They want to ensure their children inherit as much as possible without incurring significant estate taxes. They establish a Formula AB Trust. When John passes away, the trust's formula directs assets equal to the current federal estate tax exemption (for example, $13.61 million) into Trust B. Mary receives income from Trust B for her lifetime, but the principal is preserved for their children. The remaining $11.39 million of John's assets, along with all of Mary's separate assets, are placed into Trust A, over which Mary has full control. When Mary eventually passes away, her estate will utilize her own $13.61 million exemption, and the assets in Trust B will pass directly to the children, completely free of estate tax, having bypassed Mary's estate. This strategy effectively uses both John's and Mary's exemptions to minimize the overall tax burden on their legacy.

• Adapting to Changes in Tax Law:

  Consider Sarah and David, who set up their Formula AB Trust in 2018 when the federal estate tax exemption was $11.18 million. David passes away in 2024, and by then, the exemption has increased to $13.61 million. Because their trust is a Formula AB Trust, the specific amount allocated to Trust B upon David's death automatically adjusts to the higher, current exemption amount of $13.61 million. This means their estate planning remains optimized for tax efficiency without needing to update the trust document every time tax laws change, ensuring the maximum possible amount bypasses Sarah's estate tax-free.

• Ensuring Inheritance for Children from a Prior Marriage:

  Robert and Susan are in a second marriage, and Robert has two children from a previous relationship. They have a combined estate of $20 million. Robert wants to ensure his children inherit a specific portion of his wealth, while also providing for Susan during her lifetime. Their Formula AB Trust specifies that upon Robert's death, assets up to the federal estate tax exemption (e.g., $13.61 million) are placed into Trust B. The terms of Trust B dictate that Susan will receive income from these assets for the rest of her life, but upon her passing, the principal will be distributed solely to Robert's two children. This arrangement guarantees that Robert's children will ultimately receive his tax-exempt share of the estate, bypassing Susan's estate, while Susan is still financially supported by the trust's income.